U.S. Treasury exempts forex swaps from Dodd-Frank

Centralized clearing would create additional costs

The U.S. Treasury Department exempted foreign-exchange swaps and forwards from Dodd-Frank Act regulations intended to reduce risk and increase transparency in the derivatives market.

Foreign-exchange swaps and forwards are short-term transactions that already have high-levels of transparency and risk management, the department said in a statement yesterday announcing the exemption. Deutsche Bank AG, Bank of New York Mellon Corp., UBS AG and other banks urged Treasury Secretary Timothy F. Geithner to exempt the market. The exemption had been resisted by some regulators, Democratic lawmakers and advocates of tighter rules.

“Unlike other derivatives, FX swaps and forwards already trade in a highly-transparent, liquid and efficient market,” the Treasury Department said. “This final determination is narrowly tailored.”

Foreign exchange contracts were the second-largest source of derivatives trading revenue for U.S. bank holding companies in the second quarter, according to the U.S. Office of the Comptroller of the Currency. The companies recorded $3.1 billion in revenue on trading of foreign exchange derivatives.

Foreign-exchange swaps and forwards are part of a $4 trillion global daily market for foreign exchange, according to the Basel-based Bank for International Settlements.

Dodd-Frank would move most swaps to clearinghouses that collect collateral from buyers and sellers to reduce the risk that one party’s default would disrupt the broader market. The measure was enacted in response to the 2008 credit crisis that regulators and lawmakers said was fueled in part by largely unregulated swaps.

‘Additional Costs’

“Moving FX swaps and forwards to centralized clearing would not only have created additional costs for businesses and investors, but also increased systemic risk,” James Kemp, managing director of the Global Financial Markets Association’s foreign-exchange division, said in an e-mail statement. “This final decision from the U.S. Treasury provides the clarity the industry needs to now further develop the infrastructure of the future.”

In comment letters to Treasury in 2010, Democratic Senators Carl Levin of Michigan and Maria Cantwell of Washington discouraged the department from granting the exemption.

The Commodity Markets Council, a lobbying group for energy and agriculture companies and derivatives exchanges, said in a June 2011 letter that the exemption could undermine the regulatory overhaul. The council “believes exempting foreign exchange forwards and swaps at this time from the clearing and trading requirements of Dodd-Frank could increase systemic risk at a time when regulators around the globe are trying to reduce it,” according to the letter, which was submitted in response to Treasury’s proposed exemption.

‘Unjustified’ Loophole

The council includes the CME Group Inc., the Chicago-based owner of the world’s largest futures exchange; Intercontinental Exchange Inc., the Atlanta-based futures market operator; and Decatur, Illinois-based Archer-Daniels-Midland Corp., the largest U.S. grain processor.

“Wall Street fought hard to convince Treasury to grant this loophole, which is unjustified by independent research,” Dennis Kelleher, president and chief executive officer of Better Markets, an organization advocating stricter financial regulation, said in an e-mail statement. “That may be why, after two years of consideration, the United States Treasury announced such an important financial regulation decision on a Friday night at 5 p.m. when Congress is on recess and on the eve of the Thanksgiving holiday.”

Exemption Exceptions

The U.S. Commodity Futures Trading Commission and Securities and Exchange Commission are required to write rules to reduce risk and increase transparency for interest-rate, credit and other swaps in the $648 trillion global over-the- counter derivatives market.

The Treasury exempted foreign-exchange swaps and forwards from those rules. The exemptions don’t apply to Dodd-Frank’s reporting requirements and business conduct standards. The exemption also doesn’t apply to foreign-exchange options, currency swaps and non-deliverable forwards.

The foreign-exchange swaps and forwards market and its participants “have been subject to strong, comprehensive, and internationally coordinated oversight by central banks for more than three decades,” Treasury said in the announcement. The exemption takes effect when it is published in the Federal Register.

‘Unforeseen Risks’

“Treasury believes that requiring foreign exchange swaps and forwards to be cleared and settled through the use of new systems and technologies could introduce new, unforeseen risks in this market,” the department said in the final exemption order.

Darrell Duffie, a professor at Stanford University’s business school, said the foreign-exchange swaps and forwards market has taken voluntary steps to curb risks. “But the remaining amount of counter-party risk in the FX derivatives market is enormous,” Duffie said in an e-mail yesterday after the Treasury announcement. “Does the logic of this exemption imply that credit default swaps or interest rate swaps should also be exempted from regulation once practices improve in those markets? Surely that should not be the case.”

During the congressional debate over Dodd-Frank, the Treasury Department fought unsuccessfully to exclude foreign exchange from regulation over the objections of CFTC Chairman Gary Gensler.

An exclusion threatened to “swallow up the regulation” of derivatives if interest-rate or credit swaps are structured as foreign exchange swaps to benefit from the exemption, Gensler wrote in an August 2009 letter.

Steve Adamske, the CFTC’s spokesman, declined to comment on the final Treasury exemption.